Last night I watched the Dispatches documentary How The Banks Bet Your Money, on More 4.
The programme was presented by Jon Moulton of private equity firm Alchemy. It was a devastating attack on both the banks and the British Government’s regulatory regime from an insider who tried to raise the alarm earlier this year. In simple-ish terms he showed how the boarded up houses of sub-prime mortgage defaulters in Cleveland Ohio had led to the collapse of Northern Rock. There is a detailed synopsis of the programme at the Interactive Investor blog. It’s also available to download for free at the Channel 4 on-demand service for the next four weeks.
Jon Moulton ended the programme with a warning – this is not over yet. He reckons there will be more trouble ahead as banks face losses from Credit Default Swaps. Now I have no idea how these work. I found it hard to follow the Wikipedia page but I liked the quote from Warren Buffet, “financial weapons of mass destruction”.
Right on cue, the Independent carried this warning today:
The latest obscure corner of the credit market to hit trouble is the credit default swaps market, which investors use to buy protection from the risk of a default by corporate bonds. The cost of this protection soared to a record yesterday, amid rumours that packages of credit default swaps, called CPDOs, are being dumped by investors following warnings they may themselves default on their payouts.
Gretchen Morgenson of the New York Times describes the instruments as arcane and points out that, like the Collaterised Loan Obligations which led to the Northern Rock collapse, they are unregulated. She explains:
In a credit default swap, two parties enter a private contract in which the buyer of protection agrees to pay the seller premiums over a set period of time; the seller pays only if a particular credit crisis occurs, like a default. These instruments can be sold, on either end of the contract, by the insurer or the insured.
But during the credit market upheaval in August, 14 percent of trades in these contracts were unconfirmed, meaning one of the parties in the resale transaction was unidentified in trade documents and remained unknown 30 days later. In December, that number stood at 13 percent. Because these trades are unregulated, there is no requirement that all parties to a contract be told when it is sold.
As investors who have purchased such swaps try to cash them in, they may have trouble tracking down who is supposed to pay their claims.
In other words, then, credit default swaps are another dodgy financial instrument that few people understand but which could collapse in such a way as to see millions of people’s savings and pensions wiped out while their employers go to the wall.
Anyway, enough of the gloom-and-doom. If you want a light-hearted guide to the sub-prime crash and its knock-on effects, this slide show, found at the Big Picture blog, tells you all you need to know.